Learning to love risk again – Graham Parker

Economically, 2010 was a year of recovery for the US as it put the recession of 2009 behind it. Cushman & Wakefield‘s latest MarketBeat research points out: “America’s recovery gained traction over the course of 2010 as the uncertainties that had led consumers and businesses to remain cautious began to lift. Consumer and business spending picked up significantly and led to steady growth in real gross domestic product — up 2.9% for 2010.”

There are now positive signs of recovery in almost all sectors and markets and, barring unforeseen shocks, it does seem that the worst is over. “We have gone through a tumultuous economic time and the commercial real-estate markets have been dramatically affected,” says Chris Ludeman, president of CB Richard Ellis’ (CBRE) brokerage business. “And we are going to see an uneven tempo as we come out of the downturn. Some areas appear much brighter than others.”

Ludeman’s colleague Jon Southard, principal and director of forecasting at CBRE Econometric Advisors, describes the current trend as one of “choppiness”. He forecasts: “As we go through this year, we are going to see a mixed picture. But this mixed tempo is an improvement on the sometimes terrifying economic news of the past two years.”

As an example, Southard points to the February 2011 unemployment figures, which disappointed observers. “There’s a huge overhang of joblessness out there,” he says, observing that, going forward, job creation will hold the key to the improved take-up of office space.

Until now the US has seen a jobless recovery — companies have grown by improving the productivity of their existing workforce. But CBRE’s Southard believes this phase could be coming to an end. “As companies grow, they are going to have to turn to hiring if they are going to continue their recovery,” he says.

So what does this mean for the realestate markets? On the occupational front, CBRE’s Ludeman says: “We saw in 2010 a reasonably good foundation for 2011 — companies that survived saw a unique opportunity to lock in at historically positive rates. And large footprint occupiers were able to take strategic space on longer terms.”

Ludeman points out that, so far, this phenomenon has been most apparent in the core markets of New York, Boston, Chicago and Washington, DC. In 2011, however, he believes it could spread elsewhere. “We are going to see it move in a south and south-westerly direction, although there is still more confidence around the coasts than there is in the centre of the country,” he says.

Meanwhile, in those primary markets, the market dynamic is already changing. “Larger blocks of space are becoming harder to secure, especially in the core financial markets,” Ludeman adds. “But there are still a lot of opportunities for mid-size occupiers to take advantage of good quality buildings.”

So does this improving picture presage a return to rental growth? Not yet, is Luderman’s conclusion. “Landlords are starting to tighten concession packages,” he says. “That doesn’t mean the pendulum will swing back to the landlord in 2011, but it will definitely move in that direction in 2012 and will, we believe, be clearly in landlords’ favour by 2013, because there is a decided lack of new space hitting the market.

The next question is what this means for investors. Josh Gelormini, director of capital markets research at Jones Lang LaSalle, says so far investors have been targeting “top-tier markets with minimal lease risk”. However, in 2011, he expects activity to spread into other market segments. This, in turn, will drive improved market turnover. “We think for 2011 total transaction volumes will total about $92bn — an 80% increase over the historical low volumes of 2009,” he adds. And Gelormini forecasts: “For 2011 we expect many of the positive trends we saw in the market in 2010 to continue, but the mix of property types that perform well may change.” The cap-rate compression that drove investment-market performance in 2010 may not be repeated, Gelormini suggests: “For capital values to continue to improve, it will require more of a contribution from rental income increases.”

In other words, investment performance in 2011 is going to be more closely aligned with the performance of the occupational markets. And if the analysis of CBRE’s Ludeman is correct, it could be 2012 or 2013 before there is another uptick in capital values. With this in mind, Gelormini believes investors may have to become a little more adventurous in search of returns. “For 2011, one other trend to look out for is increasing demand for value-added opportunities and properties with some higher leasing-up risk into higher vacancy rates and, perhaps, secondary market locations,” he says.

New research published by the National Association of Real Estate Investment Trusts (NAREIT) shows that risk-averse institutional investors have been shutting themselves out of precisely the sort of opportunities highlighted by Gelormini. NAREIT’s economist Brad Case has analysed the make-up and the performance of institutional property portfolios over the past 18 years, and his conclusion is that most allocate their investments in a way that makes underperformance almost inevitable.

“We have seen lots of money flowing into core investments in search of lower volatility,” he says. But NAREIT is calling for more investment in non-core positions. Case’s analysis shows the typical US pension fund has 50% of its property allocation in core investments, with just 9% in REITs, 21% in opportunistic funds and the remaining 20% in value-added funds. “That produces a better return than just being in core funds, but it’s still sub-optimal, largely because the allocation to REITs is too low,” Case says. “Typically, the REIT allocation should be between a quarter and a third.”

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